The Money Must Go Somewhere

In Friday’s issue of the Economic Prism we suggested that, despite all the financial uncertainty going on, the U.S. economy is strengthening. By the response we received, this optimism astonished many of our readers. Naturally, we thought that would be the case…and promised there’d be more to follow. So allow us to explain…

To begin, we still believe things are going to hell in a hand bucket. Government debt, which recently exceeded 100 percent of gross domestic product, is a ball and chain to economic growth and dynamite to monetary stability. The debt problem isn’t going away. It will ultimately restrain the economy and bring about government default or mass inflation as the Fed prints money to lighten the debt burden.

But neither economic progress nor ruin follow a straight line. Countertrends and cyclical rallies play out making fools of believers and nonbelievers alike. At the moment we think the economy’s taking a temporary detour from its eventual destination.

Remember, the financial and economic problems we face today didn’t begin in 2008; they began nearly a century ago with the creation of the Federal Reserve. Moreover, they began in earnest in 1971 when Nixon severed the dollar’s last tie to gold. Since then debt based money creation has exploded.

Nonetheless, and despite all the government intervention, over the last 100-years real economic growth has occurred. So, too, there has been the illusion of economic growth created by an abundance of debt. Understanding and accepting that we live in a world that is both real and illusory is fundamental to making pragmatic decisions with your savings and your family’s assets.

Pushing on a Wire

Today things have become so distorted from years of extreme government tinkering with the price of money that it’s often difficult to tell the difference between real economic growth and the illusion of economic growth. Sometimes, the difference becomes crystal clear as misallocations of capital reach extremes…like with the dot com bubble of the late 1990s, the housing bubble of the mid-2000s, and, perhaps, the Treasury bond bubble today. Most of the time, however, the difference is clear as mud.

Still, what we know is, even though much of the economy’s activity is based on a creaky foundation of debt that’s perpetuated by an endless supply of paper money, the economy is strengthening. As we noted last Friday, the leading economic indicators, including manufacturing, housing, and consumer spending, are rising.

Regardless of whether it’s real economic growth or the illusion of economic growth, something is going on. The most notable of the leading economic indicators, we believe, is the increase in consumer spending. Here’s why…

The Fed inflated their monetary base from $900 billion in late 2007 to $3 trillion today. But as their monetary base tripled something remarkable happened; the money never made it into the economy. Because of the extreme fear and increase in lending standards following the housing market blow up, the transmission device for Bernanke’s funny money malfunctioned. Rather than flooding into the economy, the new money sat on bank balance sheets or was used to buy Treasuries.

This effect, or lack thereof, in central banking parlance is called pushing on a string. The central bank pushes on one end of the string by expanding the money supply and the other end of the string, which is represented by the money’s entry into the economy, doesn’t budge. Last week the Federal Reserve reported the largest increase in consumer debt in a decade. What this means is the string Bernanke’s been pushing on has turned to a wire. Credit is now flowing into the economy again for the first time in since mid-2008. Where will this lead?

The Money Must Go Somewhere

Obviously, this is a boost to the economy in the short term…it puts to use the Fed’s monetary stimulus which has sat idle in bank coffers over the last three years. Additionally, it’s inflationary. How quickly this new money makes its way into the economy, and the velocity at which it travels through the economy, will determine the extent that consumer prices increase.

The latest consumer price index release, from December 16, reported that prices were unchanged in November. On Thursday, the CPI for December will be reported. Holiday discounts may offset the rise in consumer spending. Eventually, though, the new money entering the economy must show up somewhere…

Will it flow into consumer goods? What about stocks, gold, and oil prices? It’s likely the money will go into all of these things…with potentially disruptive inflationary consequences. The new money will also encourage business activity, employment, and, unfortunately, misallocation of capital.

What isn’t clear is if this will just be a short term, three-to-six month boost or a much longer, two-to-three year boon to the economy. But, regardless of duration, it will not do a darned thing to solve the long term debt burden. In fact, it will make the problem worse as it entices consumers to go further into debt so they can get kicked in the teeth again when things fizzle out.

In the meantime, we’ll be monitoring the situation for you and apprising you accordingly. Thanks for reading.